Macro Unit 3 Summary- overall demand / supply and fiscal policy
In this section, we begin with a look at the balance of payments, followed by a discussion on the determination of the exchange rate, and in the next section of the political implications.
The balance of payments is used to record the value of transactions between residents and the rest of the world balance of payments consists of two accounts of a country.
Net exports of goods and services, the difference in value of exports minus imports, which can be written as NX 1.
The capital account, which is the difference between financial capital inflows and financial capital outflows.
1 Since the vast majority of current account deals with trade in goods and services that we will detail this component of the current account.
The balance of payments reduced to zero due to the symmetry of the current and capital accounts.
Consider buying a Japanese video made by an American this is considered an export from Japan and imported to the US When the US consumer buys the VCR, it pays in dollars which increases the value of imports in However the current account, the producer receives Japanese yen exchange dollars for yen place on exchange markets the important point is that the Japanese producers did not want dollars; Rather, they need yen to pay their employees, suppliers and dividends to shareholders Dollars return to the U S by the capital account.
We end up with a circular flow of money In the example given here, the dollars spent on a Japanese willingness VCR.
Reduce the value of exports of the current account surplus - 0 imports or increase the value current account deficit of export - import 0.
Increase the dollar supply on the foreign exchange markets, we will soon see the effect on the exchange rate of the yen, and.
U S regain the capital account.
Let's take an example Suppose the account both first current account and capital are in balance; NX 0 Now you rush out and buy a new 200 VCR Toshiba manufactured in Japan and imported to the US The result is a 200 deficit current exports 0, imports 200 Back in Japan, Toshiba's bank statement shows a credit of 200 but Toshiba needs to withdraw yen to pay the manufacturing costs as a result, Toshiba bank uses the exchange market to convert dollars into yen, so the bank credit Toshiba is effectively denominated in yen.
Because of your purchase, the supply of dollars in foreign exchange markets increased 200 Now suppose that a Japanese saver wants to buy 200 dollars of shares of shares of a US company, increasingly rapid Sun Microsystems for example, it will drop 200 yen the value of 2 in his brokerage account its investment bank will convert the 200 yen and execute the purchase of shares of Sun Microsystems shares result, your 200 is back to United States through the capital account.
2 If we assume an initial exchange rate of 1 100 Ґ, Japanese savings deposits Ó 20,000 in his account Tokyo.
Although this example is simple, it shows the basic relationship between the current account and capital in general, deficits or surpluses in both account will show up as the opposite of the other account later in this topic, we will show the link between changes in the capital account in Mexico and fluctuations in the current account Thus, the links can work in both the current account to the account of capital or capital on the current account.
There are exceptions to one a compromise between, say, the dollar is used worldwide as an alternative to transactions in the national currency Therefore, a few dollars can stay in Russia, the goods can be paid either in rubles or dollars in the markets of Moscow This is a relatively minor factor that will not affect our analysis.
Important factors that determine the current account.
When considering the current account surplus or deficit of a nation, we must consider certain determinants of the level of imports and total exports of goods and services For now, assume that his business is not influenced by trade barriers such as customs and quota-free; we will examine these effects later.
There are four main considerations when examining current account activity of a nation.
Changes in rates of economic growth and national income will have a significant influence on the amount of goods and services the country is important for GDP growth and rising consumer incomes, purchases of goods and services also increase of the increase of consumption will consist of foreign imports, for example, for every dollar uS consumers spend on goods and services, about 10 or 10 cents is spent on imported goods, so we can expect a positive correlation between economic growth and the level imports.
We must also take into account the GDP growth of the business partners of a nation High rates of growth abroad will lead to increased demand for increasing foreign consumers, exports of another country their purchases of goods and services therefore, the relative economic growth rate is the key variable If a nation's economy is growing relatively faster than its trading partners, the value of imports rise faster than exports and net exports decline .
Price fluctuations or inflation will determine the comparative prices of imports and exports for a nation A country with higher inflation than its trading partners will see exports increase in relative prices and relative prices imports fall in general.
With an increase in domestic inflation, exported goods prices also increase as foreign consumers pay a higher price for goods imported from countries with higher inflation, they are likely to switch to alternative products at low prices by domestic firms or imported from other countries.
For example, if the inflation rate in Japan increased, prices of Japanese exports worldwide also increase in tandem we assume US consumers now have to pay a higher price for goods imported from Japan, such as VCRs, cars and televisions as the relative price of Japanese imports Assume increases and other inflation rates remain stable, American consumers are seeking substitutes for consumption, such as cars manufactured in America or Korean VCRs.
The opposite is true when falling domestic inflation rate compared to the rate of inflation trading partners when the inflation rate of a country falls, the relative prices of declining exports and prices of imported goods rise in comparison.
The basic rule is the domestic inflation rate higher compared to other trading countries lead to a decrease in net exports Rising inflation increases the relative prices of exports and decrease imports in relative prices.
Lower domestic inflation compared to other trading countries lead to an increase in net exports They reduce exports in relative prices and increased imports in relative prices.
taste changes affect net exports of consumer preferences change for a number of reasons and can affect their purchases of goods National governments and producers can appeal to patriotism and support local jobs to try to increase consumption goods and services at national level in relation to imports However, over time with the increasing globalization of the world economy and production methods, it has become increasingly difficult to find goods that are really manufactured in the country increasingly, manufacturers import parts and components from all over the world to produce a commodity.
The factors that determine the comparative advantage such as production costs, technology and the skills of all workers are important considerations when considering the trade balance of the current account of a country, for example, increased technology to improve worker productivity and reduce production costs that the company passes these savings in the form of lower prices for consumer goods, exports increase as the relative price of the good falls in world markets a nation that promotes education, worker skills and technical research should see an expansion of its export markets as product quality improves and the cost reduction.
The capital account deals with the flow of money in and out of the financial markets of the nation's most important determinant of financial flows are of interest rates, which determine the rate of return on savings In addition to rate interest, we should consider.
The yield potential of foreign direct investment enterprises will consider direct investment in a country more yield potential through direct investment, a foreign company may enter into a financial agreement with a national company to provide money for expansion capital and research and development or foreign company can produce abroad of goods and services, bringing money to build production capacity.
The potential return on financial assets such as real estate and stocks will have significant effects on the capital market The combination of developing countries and volatile stock markets can lead to sudden and dramatic change of accounting currency flows capital later in this topic will examine the events in Mexico in 1994 and 1995 as an example of how hot money flows in the capital account can seriously disrupt a country.
Back in interest rates, higher interest rates is a country, the most attractive of its financial markets are both domestic and foreign investors.
While domestic interest rates rise relative to rates in other countries, the rate of return on financial markets of the country increases, which attracts savings and financial capital which leads to an increased influx money in the capital account and less money leaving the country looking higher foreign interest rates, also through the capital account.
Throughout this course, we examined how the balance is determined on different markets We started with the product market, looking at the supply and demand for good When supply equaled demand was decided that the market price As we progress, we have seen how the balance of the supply of labor demand and labor has fixed the wage rate and how to balance on the loanable funds market capital market determined interest rates next, we examined the macroeconomic markets where the interaction between aggregate demand and aggregate supply changed macroeconomic price inflation and GDP production Using the same fundamental analysis of supply and demand, we now see how exchange rates are determined.
Exchange rates give us the price of one currency relative to another like any good, the relative price of two currencies is determined by supply and demand of foreign exchange market exchange rates, we can use fundamental basis to explain how a national currency price changes relative to the other for a floating currency, its price relative to another currency is determined by the conditions of supply and demand for the currency.
Before we begin our analysis of floating exchange rates, consider two other ways in which the value of a currency can be determined.
Fixed a currency can be set to a value that will not change in relation to other currencies around the world.
Pegged the value of a currency may change, but only in relation to that of another Attaching foreign currency are favored by small developing economies that want to promote monetary stability in order to facilitate international trade, for example, Korea can stow her earned the Japanese yen until recently, Mexico has fixed the peso to the dollar at about 3 5 pesos to the dollar This means that the dollar has changed against the yen or mark, the peso modified the same magnitude as the dollar.
In some cases, the coins can be grouped, as in the European exchange rate mechanism ERM, for example, many European currencies such as the French franc and the Swedish krona is pegged to the German mark in a system known as the snake name these coins are not having to travel to the strict unison with the mark against other floating currencies the fixed exchange rate mechanism a fixed value of participating currencies against the mark with authorized currency senior members and limits below may vary from brand to the limit limit is reached either on the high end or low That creates a stable monetary system, but allows Member States some leeway in national economic policy to maintain currency a fixed level often requires the focus of monetary policy is the preservation of the exchange rate, with less concern of the national economy over time, European countries hope to establish the European currency unit ECU as a common currency for the continent.
Figure 12-1 shows the demand and supply of dollars on the foreign exchange markets we label the horizontal axis with the amount of dollars on the foreign exchange markets We will measure the dollar against the Japanese yen, so we label the vertical axis as the ratio of the yen, or the price of the dollar against the yen the dollar value is determined by demand balance for the dollar on foreign exchange markets with the supply of dollars in the same markets in this case, a dollar is worth 100 yen Ґ 100 1 or equivalent, it takes 100 yen to buy a dollar.
Now that we see how the demand and the supply of dollars in foreign exchange markets determine its value relative to other currencies, consider the changes in the dollar, we will first examine how the conditions of the current account of the impact uS dollar, then we will examine the capital account.
First, examine how a change in the economic growth affects the current account Throughout this section, it will be important to focus on the ceteris paribus condition or holding everything else constant In this case, assume that a tax cut increases the important growth uS GDP, we hold everything else constant as the inflation rate and the growth rate of Japan's GDP.
Accelerated economic growth in income and consumption increases in the United States that American consumers increase their consumption, part of this will include additional spending on imports more than 10 cents of every dollar spent by US consumers is about goods imported with increasing economic growth in the US so is spending on imports, which reduced the value of net exports.
Remember what happens when a US consumer buys an import in Baltimore, the consumer pays for a good Japanese dollar Dollars make their way to Japan through the currency markets where they are converted into yen The result is increase the dollar supply on the foreign exchange markets, as we will show below, and also increase the demand for yen that we will not show.
As US consumers increase their consumption of imports, the supply of dollars in foreign exchange markets increases Figure 12-2 shows a rightward shift the supply of dollars from S 0 to S 1 as US consumers are increasing their purchases of imports as a result, the price or value of the dollar falls from P 0 to P 1 against the yen This is also known as a dollar depreciation.
This also means that the yen has appreciated, which could also be represented by watching Yen request using the supply and demand yen and yen report.
The depreciation of the dollar could be expressed numerically, for example, the original report was dollar yen Ґ 100 1, and after the dollar depreciates say the new ratio yen dollar Ґ 90 1 Originally, a dollar would buy the equivalent of 100 Ґ Japanese goods and services to the new value, the purchasing power of a dollar fell to 90 Ґ the value of Japanese goods and services.
Consider now the capital account Build a scenario where the U S Federal Reserve uses the tight monetary policy to increase interest rates U s important, we hold constant all other economic variables, such as interest rates abroad.
In the previous example, changes in the level of imports affected the amount of dollars in the foreign exchange market through the current account, which measures trade in goods and services, changes in interest rates affect the number of dollars on the foreign exchange markets through the capital account the currency capital account measures flows of savings and financial capital or the supply of loanable funds in the current account, dollars end up in the currency markets as a result of a purchase or sale of tangible property or service money flows in the capital account in search of the most favorable rate of return, such as higher interest return or greater stability No transaction of goods and services occur in this case; only the movement of money from the money that moves either in the capital or current account always ends in the same foreign exchange market; it just takes a different route by accounting definitions to get there.
With an increase in US interest rates holding any interest rate foreign exchange, money foreign investors enter the US seeking higher returns compared Consider the Japanese saver in Yokosuka make a good purchase the US Treasury because it seeks a rate of return higher than he can win nationally deposits of saving his money with his brokerage in Japan and the broker takes the deposit of the yen and exchange yen to the dollar on the dollar foreign exchange market are then used to buy US T-bill in America Japanese investor becomes the owner of the major US T-bill, this operation increased demand dollars on the foreign exchange market dollar demand increases as the yen are traded against the dollar in the foreign exchange market to purchase T-bills
Figure 12-3 shows the impact of higher US interest rates as foreign investors send their money to the United States to buy US financial assets, the demand for dollars increases from D 0 to D 1 This increases the price or the value of the dollar against the yen from P 0 to P 1 This is known as a dollar.
We conclude this section with a chart that shows how changes in exchange rates affect the relative prices of goods is assumed that the exchange rate of the initial dollar yen Ґ 100 1 and the dollar depreciates in Ó 90 1 We review now impact -made US mountain bike and a Japanese television has made the mountain bike prices to US consumers remains at 500, while in Japan, Japanese consumers pay Ґ 36000, which what the exchange rate as the table shows, the initial exchange rate of 100 Ґ 1, Japanese consumers pay Ґ 50,000 for cycling -made imported US consumers pay 360 to buy the TV from Japan to simplify suppose that the price paid for imports reflects the market prices that foreign consumers pay.
The comparative price of goods in Japan and the United States.
Now consider the change in relative prices that consumers pay for imports when the dollar depreciates to 90 1 Ó While the price of the bike does not change for American consumers, increasing the purchasing power of the yen reduces price that Japanese consumers pay for imported bicycle Ó 45,000 well, the price of a Japanese television is purchased by uS consumers is 400 from the table, we can see that currency depreciation a country, the dollar depreciates in this example raises the price of imports and lower the price of its exports an appreciation of the currency of a nation, such as the yen, increasing the relative price of its exports, while making the cheaper imports buying for domestic consumers.
Extending this concept to net exports, there is a depreciating currency will eventually increase exports and reduce imports, the improvement in net exports, however, a currency appreciation reduces imports and exports increases , reducing net exports course, we isolate the impact of changes in the exchange rate There are many other factors at work that might work opposite or complementary to the exchange rate effect a more realistic assessment of global trade, see the first part of this section examines the factors that determine the current and capital accounts, however, we can conclude that changes in exchange rates affect the relative prices of imports and export.
So far, we studied a floating exchange rate fixed exchange rate peg or hold the value of a currency at a fixed level to another The discussion below will give examples of different ways that a country can manage its exchange rate.
One of the US economic system forces and many other countries is the independence of the Federal Reserve central bank to the executive of the political and legislative process While the president of the Federal Reserve is a political appointment as several members of the federal Open Committee of the market, once in place, they can practice independently of monetary policy to political pressure from the white House and Congress for most, presidents and Congress have been good at appointments Federal Reserve based on the appointee's qualifications and not on a probation of potential obedience to political causes.
The central bank like the Federal Reserve plays the critical role of printing and controlling the money supply if the central bank is not independent of political leaders of a nation, often inflation is the result To win the favor of voters, politicians like to spend money and distribute Since taxes are unpopular, the best source of money to spend too much to simply order the central bank to print money for the government to distribute the result is increasing amounts of money to buy a given quantity of goods and inflation quickly takes off.
In an attempt to break the strong link between the central bank and politicians, some countries have taken extreme measures to control the money supply and thus the inflation rate may be the fastest solution was recently undertaken by Ecuador Ecuador abandoned its national currency, the sucre, in favor of making the US dollar the national currency This process is known as dollarization to be clear, Ecuador now uses the same dollars that Americans use in the United States.
Some considerations of dollarization in Ecuador.
The government of Ecuador can not print dollars - that would be infringement.
The main source of dollars comes from exports and tourism.
The government of Ecuador gives a tremendous amount of power in monetary policy unless the government collects vast reserves in dollars, it will be difficult to increase the supply of money to bring down domestic interest rates .
For the purposes of trade, Ecuador is now tied to the dollar if the dollar appreciates against other currencies like the euro or the yen, Ecuador export prices will increase for consumers abroad just like they do in the States States.
For the reasons stated above, the money supply in Ecuador is very limited and the government has not the ability to print money to finance its operations If the government has a budget deficit, it must either borrow money in the financial markets by issuing securities and or raise taxes to increase revenue as a result, inflation due to excessive monetary stimulus is no longer a problem.
Is dollarization a long-term solution for Ecuador Certainly abandon the national currency and the adoption of a foreign currency is an extreme measure, both economic and social.
A short dollarization step is to use what is known as a currency board A country that implements a currency board still uses the national currency but it is necessary to take a large foreign currency at a ratio, for example in the 1990s Argentina began a currency board to limit the supply of pesos and inflation control - the source of inflation was the same as Ecuador, too pesos printed by the monetary Board of the Government Argentina, forcing the government of Argentina to hold a dollar in reserve for every peso in circulation the only way for the government to increase the number of pesos was to acquire an additional $ - mainly exports and tourism in addition, Council of the Argentina currency needed to fix the exchange rate of the peso at a rate of one peso per dollar.
The board currency of Argentina has created serious problems for Argentina and was abandoned in 2002 a major source of Argentina's problem resulted from the appreciation of the dollar, and thus the peso was fixed the dollar to a report that the dollar, and thus the peso appreciated in the 1990s, the export prices of Argentina increased Argentina is heavily dependent on agricultural exports like beef to neighboring countries the price of imports from Argentina increased to buyers in Brazil, cheaper alternatives from other countries were found such beef Peru, further damaging the economy of Argentina, which had suffered a recession began in 1998.
Even if a solution to the currency problems in Argentina seems to be obvious - allow the peso to devalue against the dollar - in fact, things were more complicated When the currency board was created, the government of Argentina lacked the ability to print pesos to reflect the ongoing deficit spending - he turns to markets external debt rather than the Government of Argentina issued huge amounts of public debt, most of the time sold foreign lenders who liked the fact that the payments were made in dollars when the government of Argentina has sold the debt, interest and any reimbursement payments are in US dollars with a currency board and a rate only an exchange, it does not really matter for the government if paid in dollars or pesos.
In early 2002, Argentina accounted for a quarter 25 of all debt sold by governments of emerging countries of Argentina companies were as big borrowers in foreign markets, which usually makes both their debt payments dollar Take the consequence of a devaluation of the peso, 3 pesos to a dollar, for example before the devaluation, the government of Argentina or business should raise a peso revenues through taxes for government sales for the company to convert to a dollar to make a dollar in debt payments after the peso devaluation to 3 pesos per dollar, government or business should increase 3 pesos nationally to convert to dollar one dollar in debt payments the price of debt service has tripled in a practical sense, with the devaluation of the peso, the government should impose an increase important and unpopular tax, and companies should increase prices to collect additional pesos for debt service.
In 2002, its financial situation deteriorated and foreign lenders stopped buying original debt in Argentina in 2002, Argentina has allowed the peso to devalue a floating currency Could not increase the extra pesos to make interest payments denominated in dollars, the Government of Argentina has failed in its external debt the government of Argentina has declared bankruptcy.
Starting in 2002, many European countries have abandoned their sovereign currencies forming the European Monetary Union EMU and create a common currency known as members of the euro area monetary union include economic powers like Germany and smaller nations, including Ireland and Portugal monetary union is the ECB European Central Bank which acts as any central bank - print money, control the money supply and interest rates, regulates banks and other activities the ECB headquarters in Brussels, Belgium.
In practice, the EMU countries undertake economic integration rather than considering multiple currencies and exchange rates, there is now a single currency for all member countries when the transactions and a single exchange rate with other major currencies Moreover, monetary policy is focused on the overall economic conditions in the euro area, not a country While remaining independent policy, tax is limited for each member country by the stability criteria as condition of membership, the stability criteria requires that when a country has a budget deficit, the deficit is more than no more than 3 of the total national GDP due to the stability criteria, countries have limited fiscal stimulus they can give to the national economy through tax and government spending policies.
Another consideration of EMU is to establish more transparent borders between member countries is much more open and tariffs are abolished The movement of goods and workers between nations among member countries Besides improving transport of goods between countries, workers have increased flexibility to move to a country that offers better employment and wages when necessary.
The economic benefits of EMU seem important and Member States have a good incentive to participate However, while EMU made tremendous progress in the economic integration of the EMU countries, each retains its political sovereignty But national politicians have lost much of their economic power to EMU authority and Majors trials ECB longevity of EMU will come when there is asymmetric shocks for an example of an asymmetric shock, assume that Germany and most other EMU countries are facing inflationary pressures at the same time, it is assumed that France has a weak national economy and French unemployment rate has been rising since the situation global economic EMC is one of a growing probability of inflation, the prudent policy of the ECB to raise interest rates to slow economic growth in the EMU and mitigate tensions i nflationnistes However, this will only increase unemployment already troubled France to a higher level.
A good analogy is to the United States where it is common for a state or region to have different economic circumstances that the country as a whole, for example, in the 1980s, when oil prices collapsed, country oil producers such as Oklahoma and Texas were injured, while much of the rest of America was helped by lower long-term gas prices rust belt describes some of the states Midwest that produced many auto and steel These states were devastated by the 1982 recession the country, while other parts of the country felt only minimal impact another example examines the dividend peace achieved in the early 1990s when the Soviet Union disintegrated in California, a state heavily dependent on the defense industry, had a local recession that the US government reduced to think of defense after the Gulf War, however, the Federal Reserve did not respond by lowering interest rates to help California, in fact, the Fed raised interest rates through much of 1994 to meet most of all macroeconomic conditions in the US with employment opportunities declined in the local economy, there was an exodus of residents in states like Colorado, where the local economy is booming and jobs were plentiful.
To return to our example in Europe if France suffers from a local recession and the ECB raises interest rates to reduce inflationary pressures in the European global macroeconomics, French workers should consider migrating to another European country job opportunities are better workers moving from California to Colorado need to adapt to the lack of access to the ocean and a few other minor changes, however, a French citizen who emigrated to Spain in need of learn a new language and adopt a very different culture.
Another consideration is in the area of income transfers to the United States, Europe and in many countries, the unemployed receive government assistance until they can find a new job, representing a transfer income of those who are working and paying taxes, the unemployed receiving benefits the problem could get interesting in EMU when a country suffers from chronic high unemployment rate in this case the high country unemployment would be a net recipient of income transfers from other EMU countries that have managed their economies better there might be some resentment thus between countries that have a long history of grievances.
Historically, no monetary union between countries never managed in the long term, at any time, a member country may vote to leave the EMU and there are many popular politicians in Europe that include leaving EMU as part of their platform the main test of the euro will come when the economic situation is very difficult for some member countries.
Macroeconomics Principles Section 12 Main, section, main, exchange dollars.
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